One of the most enduring sayings on Wall Street is "cut your losses short and let your winners run". Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen.
No one will deliberately buy a stock they believe will go down in price and be worth less than what you paid for it. However, buying stocks that drop in value is inherent to the nature of investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article we'll help you stand out from the crowd and show you how to identify when you should make your move.
Sunday, April 27, 2008
House Prices Still On The Rise
Daily Express Sat March 29th 2008, 02/04/2008.
House prices have risen by more than £30 every day over the past five years, it was revealed yesterday.The latest figures from Britain’s largest building society show that they have soared by 47 per cent since 2003.
The average value of a home has increased by 1.1 per cent in the year to the end of March, with the price of a typical house now £179,110, which is £2,027 more than the same time last year.
Last night experts insisted the findings showed that fears of a major housing market crash are unfounded. Despite the impact of the credit crunch and lenders tightening their belts, analysts say increasing demand has kept prices high.
Housing expert John Wriglesworth said “I do not believe we will have a price crash. We are an overcrowded island with an ever-growing population. People have an innate desire to be home owners and supply is short.
In those circumstances I think there is more chance of finding Elvis on the moon than house prices crashing over the next five years. Prices may not be rising as sharply as they have been but there is no sign of them going into freefall either.
The problem is that lenders are not offering the deals they were, but if you take a five year comparison house prices are way up."
House prices have risen by more than £30 every day over the past five years, it was revealed yesterday.The latest figures from Britain’s largest building society show that they have soared by 47 per cent since 2003.
The average value of a home has increased by 1.1 per cent in the year to the end of March, with the price of a typical house now £179,110, which is £2,027 more than the same time last year.
Last night experts insisted the findings showed that fears of a major housing market crash are unfounded. Despite the impact of the credit crunch and lenders tightening their belts, analysts say increasing demand has kept prices high.
Housing expert John Wriglesworth said “I do not believe we will have a price crash. We are an overcrowded island with an ever-growing population. People have an innate desire to be home owners and supply is short.
In those circumstances I think there is more chance of finding Elvis on the moon than house prices crashing over the next five years. Prices may not be rising as sharply as they have been but there is no sign of them going into freefall either.
The problem is that lenders are not offering the deals they were, but if you take a five year comparison house prices are way up."
Budget comment - Housing
Domenic Donatantonio, PlanningResource, 17/03/2008.
Planning experts have given a cautious welcome to the government's announcements that it has found sites for 70,000 extra homes on public land.
Consultancy Atisreal criticised the lack of co-ordination between national and local planning policies.
Development director Emma Andrews, said: “Identifying sites is relatively easy. The difficult part is delivering these sites through the planning system.
“The government may want to bring forward 70,000 additional homes, but it will be interesting to see how this will be achieved having regard to social, economic and environmental sustainable objectives.
“With the current focus on delivery, which of those three elements might have to give?”
RICS public policy officer James Rowlands said the commitment to making public sector land available for house building will only solve part of the land supply issues.
“Identifying sites for 70,000 new homes is a drop in the ocean when two million additional homes need to be built by 2016,” he said.
“Encouraging the re-use of existing buildings and allowing well-managed development on greenfield sites must also be encouraged if housing targets are to be met.”
Planning experts have given a cautious welcome to the government's announcements that it has found sites for 70,000 extra homes on public land.
Consultancy Atisreal criticised the lack of co-ordination between national and local planning policies.
Development director Emma Andrews, said: “Identifying sites is relatively easy. The difficult part is delivering these sites through the planning system.
“The government may want to bring forward 70,000 additional homes, but it will be interesting to see how this will be achieved having regard to social, economic and environmental sustainable objectives.
“With the current focus on delivery, which of those three elements might have to give?”
RICS public policy officer James Rowlands said the commitment to making public sector land available for house building will only solve part of the land supply issues.
“Identifying sites for 70,000 new homes is a drop in the ocean when two million additional homes need to be built by 2016,” he said.
“Encouraging the re-use of existing buildings and allowing well-managed development on greenfield sites must also be encouraged if housing targets are to be met.”
Saturday, April 26, 2008
Investors discover lucrative haven in Britain's farmland
Extracts from an article By Jerome Taylor, 17/04/2008.
As house prices fall, the cost of rural land soars to record highs; Overseas buyers and flight from cities produce 40 per cent rise in values.
The price of farmland is rising at its fastest rate for more than 30 years as wealthy city dwellers and overseas buyers seek a slice of idyllic rural England and jittery investors rush to move their money out of stocks and shares because of the global credit crunch.
In contrast to falling residential and commercial property values, the average price of farmland rose by more than 10 per cent in the first quarter of 2008, according to a study of agricultural property sales which will be published this month. "So far this year, we have seen some of the same trends we saw last year but at an even more accelerated pace," said Andrew Shirley, head of rural land research at the Knight Frank estate agency, which conducted the study.
According to the Royal Institution of Chartered Surveyors, the value of farmland rose by 28 per cent during the second half of 2007. The last time agricultural property prices increased at such a rate was during the late 1970s, when annual increases of 40 per cent were common. Knight Frank believes prices will continue to rise by between 10 and 20 per cent this year.
The increases are being fuelled by the astonishing demand for agricultural holdings at a time when food prices are at an all-time high and when very little farmland is coming up for sale. Savills Private Finance, an independent mortgage broker, said the amount of land coming on to the public market each year was down from about 600,000 acres per year in the 1960s to 125,000 acres a year today.
However, demand has never been higher. For the first time last year, so-called "lifestyle farmers" – City traders and investors who use their wealth to pursue agriculture as a hobby – overtook bona fide farmers as the chief buyers of agricultural property.
Knight Frank's figures for 2007 show that 38 per cent of farmland was bought by agricultural enthusiasts, compared to 32 per cent sold to traditional farmers. However, other estimates suggest that lifestyle farmers bought 45 per cent of the available land.
Analysts say instability in the world's financial markets is fuelling the rush for land as investors look to transfer their wealth from stocks and shares into holdings more likely to being a quick return. The price of wheat and other cereals has more than doubled in 12 months. While that means the cost of food is going up, it has also improved the profitability of arable farming and made it an attractive investment. At the same time, Britain's agricultural land is attracting interest from abroad. While more and more British farmers are buying up farms in Russia and the former Soviet states, our farmland is relatively cheap by western European standards. Fifteen per cent of British farms are now sold to overseas buyers. Last year, the Dutch overtook the Irish as the chief foreign purchasers, snapping up 6 per cent of the available property, compared to Ireland's 5.5 per cent. Investors from Denmark bought 3 per cent, as did others from Sweden, Norway and Finland. While studies show that the Irish tend to favour farmland in the west of England, northern European buyers are looking increasingly to East Anglia.
Jeremy Zeid, an arable market specialist at the estate agency Carter Jonas, said: "If anything, the credit crunch has strengthened the agricultural property market. Some people will have seen millions wiped off their investments but those who have placed some of their money into the agricultural sector will be rubbing their hands with glee.
"I would estimate that prices will continue to grow by between 10 and 20 per cent in the next 12 months. It will slightly depend on how much comes on to the market in the spring and autumn but it will pretty much be the opposite to what is happening in the residential sector, where prices are rapidly tailing off."
The boom in agricultural property is mirrored across the Atlantic. The most recent figures from the US Department of Agriculture show that the price of an average acre of arable land rose by 13 per cent in 2007 and is likely to go up by a further 15 per cent this year.
As house prices fall, the cost of rural land soars to record highs; Overseas buyers and flight from cities produce 40 per cent rise in values.
The price of farmland is rising at its fastest rate for more than 30 years as wealthy city dwellers and overseas buyers seek a slice of idyllic rural England and jittery investors rush to move their money out of stocks and shares because of the global credit crunch.
In contrast to falling residential and commercial property values, the average price of farmland rose by more than 10 per cent in the first quarter of 2008, according to a study of agricultural property sales which will be published this month. "So far this year, we have seen some of the same trends we saw last year but at an even more accelerated pace," said Andrew Shirley, head of rural land research at the Knight Frank estate agency, which conducted the study.
According to the Royal Institution of Chartered Surveyors, the value of farmland rose by 28 per cent during the second half of 2007. The last time agricultural property prices increased at such a rate was during the late 1970s, when annual increases of 40 per cent were common. Knight Frank believes prices will continue to rise by between 10 and 20 per cent this year.
The increases are being fuelled by the astonishing demand for agricultural holdings at a time when food prices are at an all-time high and when very little farmland is coming up for sale. Savills Private Finance, an independent mortgage broker, said the amount of land coming on to the public market each year was down from about 600,000 acres per year in the 1960s to 125,000 acres a year today.
However, demand has never been higher. For the first time last year, so-called "lifestyle farmers" – City traders and investors who use their wealth to pursue agriculture as a hobby – overtook bona fide farmers as the chief buyers of agricultural property.
Knight Frank's figures for 2007 show that 38 per cent of farmland was bought by agricultural enthusiasts, compared to 32 per cent sold to traditional farmers. However, other estimates suggest that lifestyle farmers bought 45 per cent of the available land.
Analysts say instability in the world's financial markets is fuelling the rush for land as investors look to transfer their wealth from stocks and shares into holdings more likely to being a quick return. The price of wheat and other cereals has more than doubled in 12 months. While that means the cost of food is going up, it has also improved the profitability of arable farming and made it an attractive investment. At the same time, Britain's agricultural land is attracting interest from abroad. While more and more British farmers are buying up farms in Russia and the former Soviet states, our farmland is relatively cheap by western European standards. Fifteen per cent of British farms are now sold to overseas buyers. Last year, the Dutch overtook the Irish as the chief foreign purchasers, snapping up 6 per cent of the available property, compared to Ireland's 5.5 per cent. Investors from Denmark bought 3 per cent, as did others from Sweden, Norway and Finland. While studies show that the Irish tend to favour farmland in the west of England, northern European buyers are looking increasingly to East Anglia.
Jeremy Zeid, an arable market specialist at the estate agency Carter Jonas, said: "If anything, the credit crunch has strengthened the agricultural property market. Some people will have seen millions wiped off their investments but those who have placed some of their money into the agricultural sector will be rubbing their hands with glee.
"I would estimate that prices will continue to grow by between 10 and 20 per cent in the next 12 months. It will slightly depend on how much comes on to the market in the spring and autumn but it will pretty much be the opposite to what is happening in the residential sector, where prices are rapidly tailing off."
The boom in agricultural property is mirrored across the Atlantic. The most recent figures from the US Department of Agriculture show that the price of an average acre of arable land rose by 13 per cent in 2007 and is likely to go up by a further 15 per cent this year.
jargon in land investments
Brownfield - a site that has previously been developed. Brownfield sites may have been used for a wide variety of former activities including, commercial buildings, housing, industry, airfields, parks and so on. These sites may even be still in use and are not necessarily ready for development.
Capital - The amount of money you invest is usually referred to as your capital.
Capital Gain - The amount your investment increases during the period of investment.
Clawback Covenant - A legal arrangement that allows a former owner to maintain a financial interest in a piece of land. It will entitle them to some of the proceeds of a subsequent sale.
Contract for Sale - This is the name of the legal document that covers any land sale in the UK and you should always carefully check the terms in it.
Covenant - Covenant is another word for an obligation on the part of an individual which is defined in a legal document. In UK land, covenants often appear on title deeds and prohibit certain uses of that land.
Density - When refering to UK land, density describes the number of buildings (usually homes) per acre.
DPP - Detailed planning permission
Deeds - These are the ownership documents issued by the Office of H.M. Land Registry.
Depreciation - The reduction in the value of an item over time.
Freehold - The title deeds of your land can be subject to different terms, freehold means that you have absolute ownership of the land as opposed to Leasehold where you are in effect renting it for an extended period.
Green Belt - Areas of land usually around towns and cities that are currently protected from development, although the Government is currently reviewing this policy.
Greenfield - An undeveloped site that is ready for development.
H. M. Land Registry - The UK government body responsible for tracking ownership of the land.
LDP - Local Development Plan. The local council's plan for its future building programme.
OPP - Outline planning permission
Open Countryside - Open farmland and fields that doesn't have the infrastructure nearby that is needed for development.
Return on investment (ROI) - Similar to Capital Gain, this simply means how much money did you make over and above your original investment. Often described as a % so if you put in £10k and got back £50k you made a 400% return on your original investment.
SSSI - Site of special scientific interest. Land that is heavily protected against development for reasons such as the flora, fauna or archaeological value of the site.
Title - In UK law, the Crown ultimately owns all of the land but grants ownership by title to others.
UDP - Unitary Development Plan. See LDP as they essentially are the same thing.
Capital - The amount of money you invest is usually referred to as your capital.
Capital Gain - The amount your investment increases during the period of investment.
Clawback Covenant - A legal arrangement that allows a former owner to maintain a financial interest in a piece of land. It will entitle them to some of the proceeds of a subsequent sale.
Contract for Sale - This is the name of the legal document that covers any land sale in the UK and you should always carefully check the terms in it.
Covenant - Covenant is another word for an obligation on the part of an individual which is defined in a legal document. In UK land, covenants often appear on title deeds and prohibit certain uses of that land.
Density - When refering to UK land, density describes the number of buildings (usually homes) per acre.
DPP - Detailed planning permission
Deeds - These are the ownership documents issued by the Office of H.M. Land Registry.
Depreciation - The reduction in the value of an item over time.
Freehold - The title deeds of your land can be subject to different terms, freehold means that you have absolute ownership of the land as opposed to Leasehold where you are in effect renting it for an extended period.
Green Belt - Areas of land usually around towns and cities that are currently protected from development, although the Government is currently reviewing this policy.
Greenfield - An undeveloped site that is ready for development.
H. M. Land Registry - The UK government body responsible for tracking ownership of the land.
LDP - Local Development Plan. The local council's plan for its future building programme.
OPP - Outline planning permission
Open Countryside - Open farmland and fields that doesn't have the infrastructure nearby that is needed for development.
Return on investment (ROI) - Similar to Capital Gain, this simply means how much money did you make over and above your original investment. Often described as a % so if you put in £10k and got back £50k you made a 400% return on your original investment.
SSSI - Site of special scientific interest. Land that is heavily protected against development for reasons such as the flora, fauna or archaeological value of the site.
Title - In UK law, the Crown ultimately owns all of the land but grants ownership by title to others.
UDP - Unitary Development Plan. See LDP as they essentially are the same thing.
Opportunity in UK land
The UK is one of the most densely populated countries on Earth and is the second most densely populated in Europe after Holland. Demand for housing continues to increase, year on year and there appears to be no end in sight. This has meant house prices continue to rise as demand outstrips supply.
The Government forecast in 2006 that the number of UK households in England would increase from 20.9 million in 2003 to 25.7 million by 2026.
This huge increase is fueled by a number of factors including:
The Government forecast in 2006 that the number of UK households in England would increase from 20.9 million in 2003 to 25.7 million by 2026.
This huge increase is fueled by a number of factors including:
- We are all living longer
- There is a rising divorce rate
- More and more people prefer single occupancy houses
- Mass immigration
- Old and poor quality housing stock
- Social aspirations
This massive home building programme puts pressure on developers to find available land either by re-developing existing sites, known as brownfield developments or by using new land such as redundant farmland.
Friday, April 25, 2008
Land investments
Hi All,
I was contacted by a company today that was into land investments,as this is something new to me i did all my usual research and found out lots of interesting articles on it.I will post the information i gathered tomorrow.
I was contacted by a company today that was into land investments,as this is something new to me i did all my usual research and found out lots of interesting articles on it.I will post the information i gathered tomorrow.
Thursday, April 24, 2008
Never-ending bull?
Dear Trader,
It never used to be possible… Historically, small time speculators and investors weren't able to trade the Forex market.
The minimum transaction sizes and strict financial requirements were so steep, that Forex trading was left to banks and major currency dealers. As such, they were the only ones who took advantage of the incredible liquidity and strong trending nature of this market.
Fortunately, new technology has allowed foreign exchange market brokers to break down the barriers and let smaller traders have a piece of the action.
This is good news when you consider that Forex market (by its very nature) is always in a ‘bull market’
You see, currencies always trade against one another. If one currency isn't doing as well, that means the opposite currency is doing that much better. For the smart trader, this means there is always a ‘bull market’ opportunity.
While it's not the same as trading in stocks or futures, with some guidance, you too can jump into this never-ending bull market.
It never used to be possible… Historically, small time speculators and investors weren't able to trade the Forex market.
The minimum transaction sizes and strict financial requirements were so steep, that Forex trading was left to banks and major currency dealers. As such, they were the only ones who took advantage of the incredible liquidity and strong trending nature of this market.
Fortunately, new technology has allowed foreign exchange market brokers to break down the barriers and let smaller traders have a piece of the action.
This is good news when you consider that Forex market (by its very nature) is always in a ‘bull market’
You see, currencies always trade against one another. If one currency isn't doing as well, that means the opposite currency is doing that much better. For the smart trader, this means there is always a ‘bull market’ opportunity.
While it's not the same as trading in stocks or futures, with some guidance, you too can jump into this never-ending bull market.
Wednesday, April 23, 2008
Conclusion
Let's run through a quick recap of the foundational concepts that we covered in our look at the most well-known stock-picking strategies and techniques:
- Most of the strategies discussed in this tutorial use the tools and techniques of fundamental analysis, whose main objective is to find the worth of a company, or its intrinsic value.
- In quantitative analysis, a company is worth the sum of its discounted cash flows. In other words, it is worth all of its future profits added together.
- Value investors, concerned with the present, look for stocks selling at a price that is lower than the estimated worth of the company, as reflected by its fundamentals. Growth investors are concerned with the future, buying companies that may be trading higher than their intrinsic worth but show the potential to grow and one day exceed their current valuations.
- The GARP strategy is a combination of both growth and value: investors concerned with 'growth at a reasonable price' look for companies that are somewhat undervalued given their growth potential.
Hope that the information was a fruitful one
Income Investing
Income investing, which aims to pick companies that provide a steady stream of income, is perhaps one of the most straightforward stock-picking strategies. When investors think of steady income they commonly think of fixed-income securities such as bonds. However, stocks can also provide a steady income by paying a solid dividend. Here we look at the strategy that focuses on finding these kinds of stocks.
Who Pays Dividends?
Income investors usually end up focusing on older, more established firms, which have reached a certain size and are no longer able to sustain higher levels of growth. These companies generally no longer are in rapidly expanding industries and so instead of reinvesting retained earnings into themselves (as many high-flying growth companies do), mature firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders.
Thus, dividends are more prominent in certain industries. Utility companies, for example, have historically paid a fairly decent dividend, and this trend should continue in the future.
Dividend Yield
Income investing is not simply about investing in companies with the highest dividends (in dollar figures). The more important gauge is the dividend yield, calculated by dividing the annual dividend per share by share price. This measures the actual return that a dividend gives the owner of the stock. For example, a company with a share price of $100 and a dividend of $6 per share has a 6% dividend yield, or 6% return from dividends. The average dividend yield for companies in the S&P 500 is 2-3%.
But income investors demand a much higher yield than 2-3%. Most are looking for a minimum 5-6% yield, which on a $1-million investment would produce an income (before taxes) of $50,000-$60,000. The driving principle behind this strategy is probably becoming pretty clear: find good companies with sustainable high dividend yields to receive a steady and predictable stream of money over the long term.
Another factor to consider with the dividend yield is a company's past dividend policy. Income investors must determine whether a prospective company can continue with its dividends. If a company has recently increased its dividend, be sure to analyze that decision. A large increase, say from 1.5% to 6%, over a short period such as a year or two, may turn out to be over-optimistic and unsustainable into the future. The longer the company has been paying a good dividend, the more likely it will continue to do so in the future. Companies that have had steady dividends over the past five, 10, 15, or even 50 years are likely to continue the trend.
An Example
There are many good companies that pay great dividends and also grow at a respectable rate. Perhaps the best example of this is Johnson & Johnson. From 1963 to 2004, Johnson & Johnson has increased its dividend every year. In fact, if you bought the stock in 1963 the dividend yield on your initial shares would have grown approximately 12% annually. Thirty years later, your earnings from dividends alone would have rendered a 48% annual return on your initial shares!
Dividends Are Not Everything
You should never invest solely on the basis of dividends. Keep in mind that high dividends don't automatically indicate a good company. Because they are paid out of a company's net income, higher dividends will result in a lower retained earnings. Problems arise when the income that would have been better re-invested into the company goes to high dividends instead.
The income investing strategy is about more than using a stock screener to find the companies with the highest dividend yield. Because these yields are only worth something if they are sustainable, income investors must be sure to analyze their companies carefully, buying only ones that have good fundamentals. Like all other strategies discussed in this tutorial, the income investing strategy has no set formula for finding a good company. To determine the sustainability of dividends by means of fundamental analysis, each individual investor must use his or her own interpretive skills and personal judgment - for this reason, we won't get into what defines a "good company".
Stock Picking, not Fixed Income
Something to remember is that dividends do not equal lower risk. The risk associated with any equity security still applies to those with high dividend yields, although the risk can be minimized by picking solid companies.
Taxes Taxes Taxes
One final important note: in most countries and states/provinces, dividend payments are taxed at the same rate as your wages. As such, these payments tend to be taxed higher than capital gains, which is a factor that reduces your overall return.
Who Pays Dividends?
Income investors usually end up focusing on older, more established firms, which have reached a certain size and are no longer able to sustain higher levels of growth. These companies generally no longer are in rapidly expanding industries and so instead of reinvesting retained earnings into themselves (as many high-flying growth companies do), mature firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders.
Thus, dividends are more prominent in certain industries. Utility companies, for example, have historically paid a fairly decent dividend, and this trend should continue in the future.
Dividend Yield
Income investing is not simply about investing in companies with the highest dividends (in dollar figures). The more important gauge is the dividend yield, calculated by dividing the annual dividend per share by share price. This measures the actual return that a dividend gives the owner of the stock. For example, a company with a share price of $100 and a dividend of $6 per share has a 6% dividend yield, or 6% return from dividends. The average dividend yield for companies in the S&P 500 is 2-3%.
But income investors demand a much higher yield than 2-3%. Most are looking for a minimum 5-6% yield, which on a $1-million investment would produce an income (before taxes) of $50,000-$60,000. The driving principle behind this strategy is probably becoming pretty clear: find good companies with sustainable high dividend yields to receive a steady and predictable stream of money over the long term.
Another factor to consider with the dividend yield is a company's past dividend policy. Income investors must determine whether a prospective company can continue with its dividends. If a company has recently increased its dividend, be sure to analyze that decision. A large increase, say from 1.5% to 6%, over a short period such as a year or two, may turn out to be over-optimistic and unsustainable into the future. The longer the company has been paying a good dividend, the more likely it will continue to do so in the future. Companies that have had steady dividends over the past five, 10, 15, or even 50 years are likely to continue the trend.
An Example
There are many good companies that pay great dividends and also grow at a respectable rate. Perhaps the best example of this is Johnson & Johnson. From 1963 to 2004, Johnson & Johnson has increased its dividend every year. In fact, if you bought the stock in 1963 the dividend yield on your initial shares would have grown approximately 12% annually. Thirty years later, your earnings from dividends alone would have rendered a 48% annual return on your initial shares!
Dividends Are Not Everything
You should never invest solely on the basis of dividends. Keep in mind that high dividends don't automatically indicate a good company. Because they are paid out of a company's net income, higher dividends will result in a lower retained earnings. Problems arise when the income that would have been better re-invested into the company goes to high dividends instead.
The income investing strategy is about more than using a stock screener to find the companies with the highest dividend yield. Because these yields are only worth something if they are sustainable, income investors must be sure to analyze their companies carefully, buying only ones that have good fundamentals. Like all other strategies discussed in this tutorial, the income investing strategy has no set formula for finding a good company. To determine the sustainability of dividends by means of fundamental analysis, each individual investor must use his or her own interpretive skills and personal judgment - for this reason, we won't get into what defines a "good company".
Stock Picking, not Fixed Income
Something to remember is that dividends do not equal lower risk. The risk associated with any equity security still applies to those with high dividend yields, although the risk can be minimized by picking solid companies.
Taxes Taxes Taxes
One final important note: in most countries and states/provinces, dividend payments are taxed at the same rate as your wages. As such, these payments tend to be taxed higher than capital gains, which is a factor that reduces your overall return.
GARP Investing
Do you feel that you now have a firm grasp of the principles of both value and growth investing? If you're comfortable with these two stock-picking methodologies, then you're ready to learn about a newer, hybrid system of stock selection. Here we take a look at growth at a reasonable price, or GARP.
What Is GARP?
The GARP strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARPers look for in a company fall right in between those sought by the value and growth investors.
What GARP Is NOT
Because GARP borrows principles from both value and growth investing, some misconceptions about the style persist. Critics of GARP claim it is a wishy-washy, fence-sitting method that fails to establish meaningful standards for distinguishing good stock picks. However, GARP doesn't deem just any stock a worthy investment. Like most respectable methodologies, it aims to identify companies that display very specific characteristics.
Another misconception is that GARP investors simply hold a portfolio with equal amounts of both value and growth stocks. Again, this is not the case: because each of their stock picks must meet a set of strict criteria, GARPers identify stocks on an individual basis, selecting stocks that have neither purely value nor purely growth characteristics, but a combination of the two.
Who Uses GARP?
One of the biggest supporters of GARP is Peter Lynch, whose philosophies we have already touched on in the section on qualitative analysis. Lynch has written several popular books, including "One Up on Wall Street" and "Learn to Earn", and in the late 1990s and early 2000 he starred in the Fidelity Investment commercials. Many consider Lynch the world's best fund manager, partly due to his 29% average annual return over a 13-year stretch from 1977-1990.
The Hybrid Characteristics
Like growth investors, GARP investors are concerned with the growth prospects of a company: they like to see positive earnings numbers for the past few years, coupled with positive earnings projections for upcoming years. But unlike their growth-investing cousins, GARP investors are skeptical of extremely high growth estimations, such as those in the 25-50% range. Companies within this range carry too much risk and unpredictability for GARPers. To them, a safer and more realistic earnings growth rate lies somewhere between 10-20%.
Something else that GARPers and growth investors share is their attention to the ROE figure. For both investing types, a high and increasing ROE relative to the industry average is an indication of a superior company.
GARPers and growth investors share other metrics to determine growth potential. They do, however, have different ideas about what the ideal levels exhibited by the different metrics should be, and both types of investors have varying tastes in what they like to see in a company. An example of what many GARPers like to see is positive cash flow or, in some cases, positive earnings momentum.
Because a variety of additional criteria can be used to evaluate growth, GARP investors can customize their stock-picking system to their personal style. Exercising subjectivity is an inherent part of using GARP. So if you use this strategy, you must analyze companies in relation to their unique contexts (just as you would with growth investing). Since there is no magic formula for confirming growth prospects, investors must rely on their own interpretation of company performance and operating conditions.
It would be hard to discuss any stock-picking strategy without mentioning its use of the P/E ratio. Although they look for higher P/E ratios than value investors do, GARPers are wary of the high P/E ratios favored by growth investors. A growth investor may invest in a company trading at 50 or 60 times earnings, but the GARP investor sees this type of investing as paying too much money for too much uncertainty. The GARPer is more likely to pick companies with P/E ratios in the 15-25 range - however, this is a rough estimate, not an inflexible rule GARPers follow without any regard for a company's context.
In addition to a preference for a lower P/E ratio, the GARP investor shares the value investor's attraction to a low price-to-book ratio (P/B) ratio, specifically a P/B of below industry average. A low P/E and P/B are the two more prominent criteria with which GARPers in part mirror value investing. They may use other similar or differing criteria, but the main idea is that a GARP investor is concerned about present valuations.
By the Numbers
Now that we know what GARP investing is, let's delve into some of the numbers that GARPers look for in potential companies.
The PEG Ratio
The PEG ratio may very well be the most important metric to any GARP investor, as it basically gauges the balance between a stock's growth potential and its value.GARP investors require a PEG no higher than 1 and, in most cases, closer to 0.5. A PEG of less than 1 implies that, at present, the stock's price is lower than it should be given its earnings growth. To the GARP investor, a PEG below 1 indicates that a stock is undervalued and warrants further analysis.
PEG at Work
Say the TSJ Sports Conglomerate, a fictional company, is trading at 19 times earnings (P/E = 19) and has earnings growing at 30%. From this you can calculate that the TSJ has a PEG of 0.63 (19/30=0.63), which is pretty good by GARP standards.
GARP at Work
Because a GARP strategy employs principles from both value and growth investing, the returns that GARPers see during certain market phases are often different than the returns strictly value or growth investors would see at those times. For instance, in a raging bull market the returns from a growth strategy are often unbeatable: in the dotcom boom of the mid- to late-1990s, for example, neither the value investor nor the GARPer could compete. However, when the market does turn, a GARPer is less likely to suffer than the growth investor.
Therefore, the GARP strategy not only fuses growth and value stock-picking criteria, but also experiences a combination of their types of returns: a value investor will do better in bearish conditions; a growth investor will do exceptionally well in a raging bull market; and a GARPer will be rewarded with more consistent and predictable returns.
Conclusion
GARP might sound like the perfect strategy, but combining growth and value investing isn't as easy as it sounds. If you don't master both strategies, you could find yourself buying mediocre rather than good GARP stocks. But as many great investors such as Peter Lynch himself have proven, the returns are definitely worth the time it takes to learn the GARP techniques.
Growth Investing
In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.
Value versus Growth
The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.
As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.
No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.
The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.
1. Strong Historical Earnings Growth?
According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. The basic idea is that if a company has displayed good growth over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.
2. Strong Forward Earnings Growth?
The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.
The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at.
3. Is Management Controlling Costs and Revenues?
The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.
By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.
4. Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.
5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.
Is Microsoft a Growth Stock?
On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls short of others. If, for instance, we were to dismiss Microsoft because of its decreased margins and not compare them to the industry's margins, we would be ignoring the industry conditions within which Microsoft functions. On the other hand, when comparing Microsoft to its industry, we must still decide how telling it is that Microsoft has higher-than-average margins. Is Microsoft a good growth stock even though its industry may be maturing and facing declining margins? Can a company of its size find enough new markets to keep expanding?
Clearly there are arguments on both sides and there is no "right" answer. What these criteria do, however, is open up doorways of analysis through which we can dig deeper into a company's condition. Because no single set of criteria is infallible, the growth investor may want to adjust a set of guidelines by adding (or omitting) criteria. So, although we've provided five basic questions, it's important to note that the purpose of the example is to provide a starting point from which you can build your own growth screens.
Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.
Value versus Growth
The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.
As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.
No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.
The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.
1. Strong Historical Earnings Growth?
According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. The basic idea is that if a company has displayed good growth over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.
2. Strong Forward Earnings Growth?
The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.
The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at.
3. Is Management Controlling Costs and Revenues?
The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.
By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.
4. Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.
5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.
Is Microsoft a Growth Stock?
On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls short of others. If, for instance, we were to dismiss Microsoft because of its decreased margins and not compare them to the industry's margins, we would be ignoring the industry conditions within which Microsoft functions. On the other hand, when comparing Microsoft to its industry, we must still decide how telling it is that Microsoft has higher-than-average margins. Is Microsoft a good growth stock even though its industry may be maturing and facing declining margins? Can a company of its size find enough new markets to keep expanding?
Clearly there are arguments on both sides and there is no "right" answer. What these criteria do, however, is open up doorways of analysis through which we can dig deeper into a company's condition. Because no single set of criteria is infallible, the growth investor may want to adjust a set of guidelines by adding (or omitting) criteria. So, although we've provided five basic questions, it's important to note that the purpose of the example is to provide a starting point from which you can build your own growth screens.
Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.
Tuesday, April 22, 2008
Value Investing
Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.
The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.
Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.
It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.
Value Investing at Work
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.
Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.
Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.
Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.
Screening for Value Stocks
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.
Qualitative aspects of value stocks:
The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.
Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.
It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.
Value Investing at Work
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.
Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.
Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.
Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.
Screening for Value Stocks
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.
Qualitative aspects of value stocks:
- Where are value stocks found? - Everywhere. Value stocks can be found trading on the NYSE, Nasdaq, AMEX, over the counter, on the FTSE, Nikkei and so on.
- In what industries are value stocks located? - Value stocks can be located in any industry, including energy, finance and even technology (contrary to popular belief).
- In what industries are value stocks most often located? - Although value stocks can be located anywhere, they are often located in industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term. For example, the auto industry's cyclical nature allows for periods of undervaluation of companies such as Ford or GM.
- Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value. A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.
Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
- Share price should be no more than two-thirds of intrinsic worth.
- Look at companies with P/E ratios at the lowest 10% of all equity securities.
- PEG should be less than one.
- Stock price should be no more than tangible book value.
- There should be no more debt than equity (i.e. D/E ratio <>
- Current assets should be two times current liabilities.
- Dividend yield should be at least two-thirds of the long-term AAA bond yield
- Earnings growth should be at least 7% per annum compounded over the last 10 years.
The P/E and PEG Ratios
Contrary to popular belief, value investing is not simply about investing in low P/E stocks. It's just that stocks which are undervalued will often reflect this undervaluation through a low P/E ratio, which should simply provide a way to compare companies within the same industry. For example, if the average P/E of the technology consulting industry is 20, a company trading in that industry at 15 times earnings should sound some bells in the heads of value investors.
Another popular metric for valuing a company's intrinsic value is the PEG ratio, calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.
Narrowing It Down Even Further
One well-known and accepted method of picking value stocks is the net-net method. This method states that if a company is trading at two-thirds of its current assets, no other gauge of worth is necessary. The reasoning behind this is simple: if a company is trading at this level, the buyer is essentially getting all the permanent assets of the company (including property, equipment, etc) and the company's intangible assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading this low are few and far between.
The Margin of Safety
A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.
This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.
Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!
Qualitative Analysis
Fundamental analysis has a very wide scope. Valuing a company involves not only crunching numbers and predicting cash flows but also looking at the general, more subjective qualities of a company. Here we will look at how the analysis of qualitative factors is used for picking a stock.
Management
The backbone of any successful company is strong management. The people at the top ultimately make the strategic decisions and therefore serve as a crucial factor determining the fate of the company. To assess the strength of management, investors can simply ask the standard five Ws: who, where, what, when and why?
Who?
Do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, COO and CIO are. Then you can move onto the next question.
Where?
You need to find out where these people come from, specifically, their educational and employment backgrounds. Ask yourself if these backgrounds make the people suitable for directing the company in its industry. A management team consisting of people who come from completely unrelated industries should raise questions. If the CEO of a newly-formed mining company previously worked in the industry, ask yourself whether he or she has the necessary qualities to lead a mining company to success.
What and When?
What is the management philosophy? In other words, in what style do these people intend to manage the company? Some managers are more personable, promoting an open, transparent and flexible way of running the business. Other management philosophies are more rigid and less adaptable, valuing policy and established logic above all in the decision-making process. You can discern the style of management by looking at its past actions or by reading the annual report's management, discussion & analysis (MD&A) section. Ask yourself if you agree with this philosophy, and if it works for the company, given its size and the nature of its business.
Once you know the style of the managers, find out when this team took over the company. Jack Welch, for example, was CEO of General Electric for over 20 years. His long tenure is a good indication that he was a successful and profitable manager; otherwise, the shareholders and the board of directors wouldn't have kept him around. If a company is doing poorly, one of the first actions taken is management restructuring, which is a nice way of saying "a change in management due to poor results". If you see a company continually changing managers, it may be a sign to invest elsewhere.
At the same time, although restructuring is often brought on by poor management, it doesn't automatically mean the company is doomed. For example, Chrysler Corp was on the brink of bankruptcy when Lee Iacocca, the new CEO, came in and installed a new management team that renewed Chrysler's status as a major player in the auto industry. So, management restructuring may be a positive sign, showing that a struggling company is making efforts to improve its outlook and is about to see a change for the better.
Why?
A final factor to investigate is why these people have become managers. Look at the manager's employment history, and try to see if these reasons are clear. Does this person have the qualities you believe are needed to make someone a good manager for this company? Has s/he been hired because of past successes and achievements, or has s/he acquired the position through questionable means, such as self-appointment after inheriting the company?
Know What a Company Does and How it Makes Money
A second important factor to consider when analyzing a company's qualitative factors is its product(s) or service(s). How does this company make money? In fancy MBA parlance, the question would be "What is the company's business model?"
Knowing how a company's activities will be profitable is fundamental to determining the worth of an investment. Often, people will boast about how profitable they think their new stock will be, but when you ask them what the company does, it seems their vision for the future is a little blurry: "Well, they have this high-tech thingamabob that does something with fiber-optic cables… ." If you aren't sure how your company will make money, you can't really be sure that its stock will bring you a return.
One of the biggest lessons taught by the dotcom bust of the late '90s is that not understanding a business model can have dire consequences. Many people had no idea how the dotcom companies were making money, or why they were trading so high. In fact, these companies weren't making any money; it's just that their growth potential was thought to be enormous. This led to overzealous buying based on a herd mentality, which in turn led to a market crash. But not everyone lost money when the bubble burst: Warren Buffett didn't invest in high-tech primarily because he didn't understand it. Although he was ostracized for this during the bubble, it saved him billions of dollars in the ensuing dotcom fallout. You need a solid understanding of how a company actually generates revenue in order to evaluate whether management is making the right decisions.
Industry/Competition
Aside from having a general understanding of what a company does, you should analyze the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. Of course, discerning a company's stage of growth will involve approximation, but common sense can go a long way: it's not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It's just a matter of asking yourself if the demand for the industry is growing.
Market share is another important factor. Look at how Microsoft thoroughly dominates the market for operating systems. Anyone trying to enter this market faces huge obstacles because Microsoft can take advantage of economies of scale. This does not mean that a company in a near monopoly situation is guaranteed to remain on top, but investing in a company that tries to take on the "500-pound gorilla" is a risky venture.
Barriers against entry into a market can also give a company a significant qualitative advantage. Compare, for instance, the restaurant industry to the automobile or pharmaceuticals industries. Anybody can open up a restaurant because the skill level and capital required are very low. The automobile and pharmaceuticals industries, on the other hand, have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents and so on. The harder it is for competition to enter an industry, the greater the advantage for existing firms.
Brand Name
A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in the world: Coca-Cola. Many estimate that the intangible value of Coke's brand name is in the billions of dollars! Massive corporations such as Procter & Gamble rely on hundreds of popular brand names like Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.
Keep in mind that some stock-pickers steer clear of any company that is branded around one individual. They do so because, if a company is tied too closely to one person, any bad news regarding that person may hinder the company's share performance even if the news has nothing to do with company operations. A perfect example of this is the troubles faced by
Martha Stewart Omnimedia as a result of Stewart's legal problems in 2004.
Don't Overcomplicate
You don't need a PhD in finance to recognize a good company. In his book "One Up on Wall Street", Peter Lynch discusses a time when his wife drew his attention to a great product with phenomenal marketing. Hanes was test marketing a product called L'eggs: women's pantyhose packaged in colorful plastic egg shells. Instead of selling these in department or specialty stores, Hanes put the product next to the candy bars, soda and gum at the checkouts of supermarkets - a brilliant idea since research showed that women frequented the supermarket about 12 times more often than the traditional outlets for pantyhose. The product was a huge success and became the second highest-selling consumer product of the 1970s.
Most women at the time would have easily seen the popularity of this product, and Lynch's wife was one of them. Thanks to her advice, he researched the company a little deeper and turned his investment in Hanes into a solid earner for Fidelity, while most of the male managers on Wall Street missed out. The point is that it's not only Wall Street analysts who are privy to information about companies; average everyday people can see such wonders too. If you see a local company expanding and doing well, dig a little deeper, ask around. Who knows, it may be the next Hanes.
Conclusion
Assessing a company from a qualitative standpoint and determining whether you should invest in it are as important as looking at sales and earnings. This strategy may be one of the simplest, but it is also one of the most effective ways to evaluate a potential investment.
Management
The backbone of any successful company is strong management. The people at the top ultimately make the strategic decisions and therefore serve as a crucial factor determining the fate of the company. To assess the strength of management, investors can simply ask the standard five Ws: who, where, what, when and why?
Who?
Do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, COO and CIO are. Then you can move onto the next question.
Where?
You need to find out where these people come from, specifically, their educational and employment backgrounds. Ask yourself if these backgrounds make the people suitable for directing the company in its industry. A management team consisting of people who come from completely unrelated industries should raise questions. If the CEO of a newly-formed mining company previously worked in the industry, ask yourself whether he or she has the necessary qualities to lead a mining company to success.
What and When?
What is the management philosophy? In other words, in what style do these people intend to manage the company? Some managers are more personable, promoting an open, transparent and flexible way of running the business. Other management philosophies are more rigid and less adaptable, valuing policy and established logic above all in the decision-making process. You can discern the style of management by looking at its past actions or by reading the annual report's management, discussion & analysis (MD&A) section. Ask yourself if you agree with this philosophy, and if it works for the company, given its size and the nature of its business.
Once you know the style of the managers, find out when this team took over the company. Jack Welch, for example, was CEO of General Electric for over 20 years. His long tenure is a good indication that he was a successful and profitable manager; otherwise, the shareholders and the board of directors wouldn't have kept him around. If a company is doing poorly, one of the first actions taken is management restructuring, which is a nice way of saying "a change in management due to poor results". If you see a company continually changing managers, it may be a sign to invest elsewhere.
At the same time, although restructuring is often brought on by poor management, it doesn't automatically mean the company is doomed. For example, Chrysler Corp was on the brink of bankruptcy when Lee Iacocca, the new CEO, came in and installed a new management team that renewed Chrysler's status as a major player in the auto industry. So, management restructuring may be a positive sign, showing that a struggling company is making efforts to improve its outlook and is about to see a change for the better.
Why?
A final factor to investigate is why these people have become managers. Look at the manager's employment history, and try to see if these reasons are clear. Does this person have the qualities you believe are needed to make someone a good manager for this company? Has s/he been hired because of past successes and achievements, or has s/he acquired the position through questionable means, such as self-appointment after inheriting the company?
Know What a Company Does and How it Makes Money
A second important factor to consider when analyzing a company's qualitative factors is its product(s) or service(s). How does this company make money? In fancy MBA parlance, the question would be "What is the company's business model?"
Knowing how a company's activities will be profitable is fundamental to determining the worth of an investment. Often, people will boast about how profitable they think their new stock will be, but when you ask them what the company does, it seems their vision for the future is a little blurry: "Well, they have this high-tech thingamabob that does something with fiber-optic cables… ." If you aren't sure how your company will make money, you can't really be sure that its stock will bring you a return.
One of the biggest lessons taught by the dotcom bust of the late '90s is that not understanding a business model can have dire consequences. Many people had no idea how the dotcom companies were making money, or why they were trading so high. In fact, these companies weren't making any money; it's just that their growth potential was thought to be enormous. This led to overzealous buying based on a herd mentality, which in turn led to a market crash. But not everyone lost money when the bubble burst: Warren Buffett didn't invest in high-tech primarily because he didn't understand it. Although he was ostracized for this during the bubble, it saved him billions of dollars in the ensuing dotcom fallout. You need a solid understanding of how a company actually generates revenue in order to evaluate whether management is making the right decisions.
Industry/Competition
Aside from having a general understanding of what a company does, you should analyze the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. Of course, discerning a company's stage of growth will involve approximation, but common sense can go a long way: it's not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It's just a matter of asking yourself if the demand for the industry is growing.
Market share is another important factor. Look at how Microsoft thoroughly dominates the market for operating systems. Anyone trying to enter this market faces huge obstacles because Microsoft can take advantage of economies of scale. This does not mean that a company in a near monopoly situation is guaranteed to remain on top, but investing in a company that tries to take on the "500-pound gorilla" is a risky venture.
Barriers against entry into a market can also give a company a significant qualitative advantage. Compare, for instance, the restaurant industry to the automobile or pharmaceuticals industries. Anybody can open up a restaurant because the skill level and capital required are very low. The automobile and pharmaceuticals industries, on the other hand, have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents and so on. The harder it is for competition to enter an industry, the greater the advantage for existing firms.
Brand Name
A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in the world: Coca-Cola. Many estimate that the intangible value of Coke's brand name is in the billions of dollars! Massive corporations such as Procter & Gamble rely on hundreds of popular brand names like Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.
Keep in mind that some stock-pickers steer clear of any company that is branded around one individual. They do so because, if a company is tied too closely to one person, any bad news regarding that person may hinder the company's share performance even if the news has nothing to do with company operations. A perfect example of this is the troubles faced by
Martha Stewart Omnimedia as a result of Stewart's legal problems in 2004.
Don't Overcomplicate
You don't need a PhD in finance to recognize a good company. In his book "One Up on Wall Street", Peter Lynch discusses a time when his wife drew his attention to a great product with phenomenal marketing. Hanes was test marketing a product called L'eggs: women's pantyhose packaged in colorful plastic egg shells. Instead of selling these in department or specialty stores, Hanes put the product next to the candy bars, soda and gum at the checkouts of supermarkets - a brilliant idea since research showed that women frequented the supermarket about 12 times more often than the traditional outlets for pantyhose. The product was a huge success and became the second highest-selling consumer product of the 1970s.
Most women at the time would have easily seen the popularity of this product, and Lynch's wife was one of them. Thanks to her advice, he researched the company a little deeper and turned his investment in Hanes into a solid earner for Fidelity, while most of the male managers on Wall Street missed out. The point is that it's not only Wall Street analysts who are privy to information about companies; average everyday people can see such wonders too. If you see a local company expanding and doing well, dig a little deeper, ask around. Who knows, it may be the next Hanes.
Conclusion
Assessing a company from a qualitative standpoint and determining whether you should invest in it are as important as looking at sales and earnings. This strategy may be one of the simplest, but it is also one of the most effective ways to evaluate a potential investment.
Fundamental Analysis
Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.
The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.
Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today.
The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.
Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.
The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.
This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.
Putting Theory into Practice
The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.
The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.
Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today.
The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.
Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.
The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.
This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.
Putting Theory into Practice
The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.
Stock-Picking Strategies: Introduction
When it comes to personal finance and the accumulation of wealth, few subjects are more talked about than stocks. It's easy to understand why: playing the stock market is thrilling. But on this financial roller-coaster ride, we all want to experience the ups without the downs.
Let us examine some of the most popular strategies for finding good stocks (or at least avoiding bad ones). In other words, we'll explore the art of stock-picking - selecting stocks based on a certain set of criteria, with the aim of achieving a rate of return that is greater than the market's overall average.
Before exploring the vast world of stock-picking methodologies, we should address a few misconceptions. Many investors new to the stock-picking scene believe that there is some infallible strategy that, once followed, will guarantee success. There is no foolproof system for picking stocks! If you are reading this tutorial in search of a magic key to unlock instant wealth, we're sorry, but we know of no such key.
This doesn't mean you can't expand your wealth through the stock market. It's just better to think of stock-picking as an art rather than a science. There are a few reasons for this:
Let us examine some of the most popular strategies for finding good stocks (or at least avoiding bad ones). In other words, we'll explore the art of stock-picking - selecting stocks based on a certain set of criteria, with the aim of achieving a rate of return that is greater than the market's overall average.
Before exploring the vast world of stock-picking methodologies, we should address a few misconceptions. Many investors new to the stock-picking scene believe that there is some infallible strategy that, once followed, will guarantee success. There is no foolproof system for picking stocks! If you are reading this tutorial in search of a magic key to unlock instant wealth, we're sorry, but we know of no such key.
This doesn't mean you can't expand your wealth through the stock market. It's just better to think of stock-picking as an art rather than a science. There are a few reasons for this:
- So many factors affect a company's health that it is nearly impossible to construct a formula that will predict success. It is one thing to assemble data that you can work with, but quite another to determine which numbers are relevant.
- A lot of information is intangible and cannot be measured. The quantifiable aspects of a company, such as profits, are easy enough to find. But how do you measure the qualitative factors, such as the company's staff, its competitive advantages, its reputation and so on? This combination of tangible and intangible aspects makes picking stocks a highly subjective, even intuitive process.
Because of the human (often irrational) element inherent in the forces that move the stock market, stocks do not always do what you anticipate they'll do. Emotions can change quickly and unpredictably. And unfortunately, when confidence turns into fear, the stock market can be a dangerous place.
The bottom line is that there is no one way to pick stocks. Better to think of every stock strategy as nothing more than an application of a theory - a "best guess" of how to invest. And sometimes two seemingly opposed theories can be successful at the same time. Perhaps just as important as considering theory, is determining how well an investment strategy fits your personal outlook, time frame, risk tolerance and the amount of time you want to devote to investing and picking stocks.
At this point, you may be asking yourself why stock-picking is so important. Why worry so much about it? Why spend hours doing it? The answer is simple: wealth. If you become a good stock-picker, you can increase your personal wealth exponentially. Take Microsoft, for example. Had you invested in Bill Gates' brainchild at its IPO back in 1986 and simply held that investment, your return would have been somewhere in the neighborhood of 35,000% by spring of 2004. In other words, over an 18-year period, a $10,000 investment would have turned itself into a cool $3.5 million! (In fact, had you had this foresight in the bull market of the late '90s, your return could have been even greater.) With returns like this, it's no wonder that investors continue to hunt for "the next Microsoft".
Without further ado, let's start by delving into one of the most basic and crucial aspects of stock-picking: fundamental analysis, whose theory underlies all of the strategies we explore here (with the exception of the last section on technical analysis). Although there are many differences between each strategy, they all come down to finding the worth of a company. Keep this in mind as we move forward.
Conclusion
After reading this, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.
Some points to remember:
- Inflation is a sustained increase in the general level of prices for goods and services.
- When inflation goes up, there is a decline in the purchasing power of money.
- Variations on inflation include deflation, hyperinflation and stagflation.
- Two theories as to the cause of inflation are demand-pull inflation and cost-push inflation
- When there is unanticipated inflation, creditors lose, people on a fixed-income lose, "menu costs" go up, uncertainty reduces spending and exporters aren't as competitive.
- Lack of inflation (or deflation) is not necessarily a good thing.
- Inflation is measured with a price index.
- The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes.
- Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates.
- In the long term, stocks are good protection against inflation.
- Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
- Inflation-indexed securities offer protection against inflation but offer low returns
Inflation And Investments
When it comes to inflation, the question on many investors' minds is: "How will it affect my investments?" This is an especially important issue for people living on a fixed income, such as retirees.
The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night. Over the long run, a company's revenue and earnings should increase at the same pace as inflation. The exception to this is stagflation. The combination of a bad economy with an increase in costs is bad for stocks. Also, a company is in the same situation as a normal consumer - the more cash it carries, the more its purchasing power decreases with increases in inflation.
The main problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.
Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.
This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).
As an investor, you must look at your real rate of return. Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.
Inflation-Indexed Bonds
There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation.
This may sound like a good thing, but the running joke on Wall Street is that it's easier to sell an air conditioner in the dead of winter than it is to convince investors they need protection from inflation. Inflation has been so low in recent years that it hasn't been much of an issue. Because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-indexed securities simply don't make sense.
The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night. Over the long run, a company's revenue and earnings should increase at the same pace as inflation. The exception to this is stagflation. The combination of a bad economy with an increase in costs is bad for stocks. Also, a company is in the same situation as a normal consumer - the more cash it carries, the more its purchasing power decreases with increases in inflation.
The main problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.
Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.
This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).
As an investor, you must look at your real rate of return. Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.
Inflation-Indexed Bonds
There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation.
This may sound like a good thing, but the running joke on Wall Street is that it's easier to sell an air conditioner in the dead of winter than it is to convince investors they need protection from inflation. Inflation has been so low in recent years that it hasn't been much of an issue. Because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-indexed securities simply don't make sense.
Inflation And Interest Rates
Whenever you hear the latest inflation update on the news, chances are that interest rates are mentioned in the same breath.
In the United States, interest rates are decided by the Federal Reserve. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed's decision.
Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth.
Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in the problems we mentioned earlier. At the other extreme, an economy with no inflation has essentially stagnated. The right level of economic growth, and thus inflation, is somewhere in the middle. It's the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.
Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed's decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown.
In the United States, interest rates are decided by the Federal Reserve. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed's decision.
Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth.
Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in the problems we mentioned earlier. At the other extreme, an economy with no inflation has essentially stagnated. The right level of economic growth, and thus inflation, is somewhere in the middle. It's the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.
Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed's decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown.
How Is It Measured?
Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year.
In North America, there are two main price indexes that measure inflation:
In North America, there are two main price indexes that measure inflation:
- Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics.
- Producer Price Indexes (PPI) - A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.
You can think of price indexes as large surveys. Each month, the U.S. Bureau of Labor Statistics contacts thousands of retail stores, service establishments, rental units and doctors' offices to obtain price information on thousands of items used to track and measure price changes in the CPI. They record the prices of about 80,000 items each month, which represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased.
In the long run, the various PPIs and the CPI show a similar rate of inflation. This is not the case in the short run, as PPIs often increase before the CPI. In general, investors follow the CPI more than the PPIs.
What Is Inflation?
Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can't buy the same goods it could beforehand.
There are several variations on inflation:
The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can't buy the same goods it could beforehand.
There are several variations on inflation:
- Deflation is when the general level of prices is falling. This is the opposite of inflation
- Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
- Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.
In recent years, most developed countries have attempted to sustain an inflation rate of 2-3%.
Causes of Inflation
Economists wake up in the morning hoping for a chance to debate the causes of inflation. There is no one cause that's universally agreed upon, but at least two theories are generally accepted:
Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.
Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.
Costs of Inflation
Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different people in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.
Problems arise when there is unanticipated inflation:
- Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
- Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
- People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
- The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus and more have to be updated.
- If the inflation rate is greater than that of other countries, domestic products become less competitive.
People like to complain about prices going up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages.
Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad - it depends on the overall economy as well as your personal situation.
Inflation
During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, bread, cars, houses and just about everything else cost more. A lot more. Clearly, we've experienced a significant amount of inflation over the last 60 years.
When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain fearful of inflation, even at the minimal levels we've seen over the past few years. Although it's common knowledge that prices go up over time, the general population doesn't understand the forces behind inflation.
What causes inflation? How does it affect your standard of living?
When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain fearful of inflation, even at the minimal levels we've seen over the past few years. Although it's common knowledge that prices go up over time, the general population doesn't understand the forces behind inflation.
What causes inflation? How does it affect your standard of living?
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Do leave comments or pen down questions and i would try my best to get them answered
Do leave comments or pen down questions and i would try my best to get them answered
Monday, April 21, 2008
Has Your Fund Manager Been Through A Bear Market?
Securities indexes in the U.S. and in many countries around the world are on course to record their fifth consecutive year of positive gains in 2007. These gains come on the heels of the dreadful equity returns experienced during the dotcom bust from 2000 through 2002. You should try to enjoy gains while you can, keep in mind that bull markets do not last indefinitely. Therefore, if you are looking to add a mutual fund to your portfolio, it will be harder to find a manager with experience in a down market.
The Shrinking Supply of Fund Managers
History shows that the most successful fund managers are those who perform well in down markets as well as in up markets, but although there are many fund managers with terrific three- and five-year performance records, many have insufficient experience during market corrections. In a report to shareholders in 2003, David J. Winters, CFA, the former Chief Investment Officer of Franklin Mutual Advisers, stated: "At Mutual Series, we believe that successful investing is as much about avoiding risk and containing losses, thereby protecting shareholder capital, as it is about achieving profits."
Unfortunately, not all funds have managers with real-world experience in how to do this. This is compounded by the fact that not all investment strategies experience bear-market performances at the same time or in the same magnitude. For example, funds investing in large U.S. companies experienced a major downturn from 2000 through 2002, the worst correction since the 1974 to 1975 period, which almost destroyed the mutual fund industry.
The Quest for a Large Cap Fund Manager
According to Morningstar, there were 5,579 domestic large cap mutual funds in 2007, some with excellent returns over the past three and five years. However, within this universe, only 1,356 of the funds have managers with experience going back as far as the beginning of the year 2000 – that cuts out almost 76% of the original universe of available funds. These 1,356 funds sound like a lot, but if you were to narrow the universe down to, say, no-load mutual funds with reasonable minimum investments that are available to the average investor, then the list would shrink down to about 150.
Small Cap Fund Managers are Even Harder to Find
To examine the small cap universe, we need to extend the time period back to 1998, which was the last period of poor relative performance for small cap stocks. According to Morningstar Research, there were 2,011 domestic small cap funds in 2007, some with superb performance records over the past three and five years, especially compared to large cap funds. However, within this universe, there are only 260 funds that have managers with experience that dates back to 1998 - eliminating 87% of this universe. Of course, if we were to refine the small cap universe to no-load mutual funds with reasonable minimum investments that are available to the average investor, the universe would shrink to about 40 funds, leaving you with very little choice.
The Search for a High-Yield Fund Manager
Some fixed-income categories have also experienced very good fortune over the past several years, making it increasingly difficult to find a manager with experience in choppy waters. For example, high-yield funds experienced a difficult period in 2002, when some of the telecommunications companies like WorldCom defaulted on their debt. In 2007, there are 575 high-yield funds, commonly referred to as junk bond funds, compared to only about 230 after narrowing the universe to managers that endured the 2002 debacle. Further, this universe is substantially reduced to about 15 when excluding load funds and other funds that most investors cannot purchase.
The Shortage Extends to International Funds
The shortage of managers extends to international mutual funds as well. International markets also last tumbled dramatically during the 2000 to 2002 period. Currently, there are 1,318 large cap diversified international funds versus 263 funds with a manager steering his or her ship since 2000. That reduces the list by about 80%! Further, if you were to narrow the criteria to include only no-load mutual funds that are generally available to the average investor, your list would shrink to only about 20 funds.
The significant reduction in international funds with managers who have experienced a bear market is partly related to the recent growth in the number of funds in international investment categories. International markets have soared over the past several years, which has led to fund companies launching more international funds.
What are your other options?
Ideally, you would want to find and invest with a manager that has successfully guided his or her fund through downturns in the market. If this search yields no results to your liking, you have a few options:
The Shrinking Supply of Fund Managers
History shows that the most successful fund managers are those who perform well in down markets as well as in up markets, but although there are many fund managers with terrific three- and five-year performance records, many have insufficient experience during market corrections. In a report to shareholders in 2003, David J. Winters, CFA, the former Chief Investment Officer of Franklin Mutual Advisers, stated: "At Mutual Series, we believe that successful investing is as much about avoiding risk and containing losses, thereby protecting shareholder capital, as it is about achieving profits."
Unfortunately, not all funds have managers with real-world experience in how to do this. This is compounded by the fact that not all investment strategies experience bear-market performances at the same time or in the same magnitude. For example, funds investing in large U.S. companies experienced a major downturn from 2000 through 2002, the worst correction since the 1974 to 1975 period, which almost destroyed the mutual fund industry.
The Quest for a Large Cap Fund Manager
According to Morningstar, there were 5,579 domestic large cap mutual funds in 2007, some with excellent returns over the past three and five years. However, within this universe, only 1,356 of the funds have managers with experience going back as far as the beginning of the year 2000 – that cuts out almost 76% of the original universe of available funds. These 1,356 funds sound like a lot, but if you were to narrow the universe down to, say, no-load mutual funds with reasonable minimum investments that are available to the average investor, then the list would shrink down to about 150.
Small Cap Fund Managers are Even Harder to Find
To examine the small cap universe, we need to extend the time period back to 1998, which was the last period of poor relative performance for small cap stocks. According to Morningstar Research, there were 2,011 domestic small cap funds in 2007, some with superb performance records over the past three and five years, especially compared to large cap funds. However, within this universe, there are only 260 funds that have managers with experience that dates back to 1998 - eliminating 87% of this universe. Of course, if we were to refine the small cap universe to no-load mutual funds with reasonable minimum investments that are available to the average investor, the universe would shrink to about 40 funds, leaving you with very little choice.
The Search for a High-Yield Fund Manager
Some fixed-income categories have also experienced very good fortune over the past several years, making it increasingly difficult to find a manager with experience in choppy waters. For example, high-yield funds experienced a difficult period in 2002, when some of the telecommunications companies like WorldCom defaulted on their debt. In 2007, there are 575 high-yield funds, commonly referred to as junk bond funds, compared to only about 230 after narrowing the universe to managers that endured the 2002 debacle. Further, this universe is substantially reduced to about 15 when excluding load funds and other funds that most investors cannot purchase.
The Shortage Extends to International Funds
The shortage of managers extends to international mutual funds as well. International markets also last tumbled dramatically during the 2000 to 2002 period. Currently, there are 1,318 large cap diversified international funds versus 263 funds with a manager steering his or her ship since 2000. That reduces the list by about 80%! Further, if you were to narrow the criteria to include only no-load mutual funds that are generally available to the average investor, your list would shrink to only about 20 funds.
The significant reduction in international funds with managers who have experienced a bear market is partly related to the recent growth in the number of funds in international investment categories. International markets have soared over the past several years, which has led to fund companies launching more international funds.
What are your other options?
Ideally, you would want to find and invest with a manager that has successfully guided his or her fund through downturns in the market. If this search yields no results to your liking, you have a few options:
- First, you could invest with a manager who has steered another fund at his or her current company through a down market. This might be a reasonable alternative if the fund company employs a team approach, thereby making portfolio managers more interchangeable.
- Second, you could invest with a manager with bear market experience at another firm. Be careful if you choose this option because fund managers do not always bring their resources with them to a new company. A different environment with a new research staff may result in a very different performance record.
- Finally, if you still cannot find a suitable fund, you could simply hire the manager with the best overall investment background.
Other Factors to Consider
Bear market experience is not the only factor to consider when investing in a mutual fund. You should of course evaluate how the manager performs in a strong market. Be careful here because sometimes unusually positive returns can indicate that the fund is much more aggressive than it peers and may not provide much downside protection.
After you have evaluated performance, both good and bad, you should consider a portfolio manager's academic experience and other qualifications. Today, fund companies tend to be very selective when it comes to hiring portfolio managers. If many of the major fund companies value strong academic credentials, they should also be important to you. Besides, you do not necessarily have to pay more for a fund manager with a strong academic background.
Similarly, many fund companies often require that managers be CFA charterholders. The CFA program is very comprehensive and is generally considered to be the gold standard for investment professionals. Again, if mutual fund companies value the CFA designation, it makes sense that it should also be important to anyone who is searching for a fund to add to a portfolio.
Another factor you may want to consider before making a new investment is whether a portfolio manager invests in his or her own fund. This information, however, is not always easy to obtain, but sometimes can be found in a fund's statement of additional information. This is not an exact science, but it can be reassuring to know that your manager's interests are in line with yours.
Wrapping It Up
Finding a fund manager with experience in a bear market is likely to continue to be a challenge as long as a streak of good mutual fund returns continues. This is not to say that it is impossible to find a manager capable of weathering the next downturn, but that mutual fund investors will have to work harder to find experienced managers. There are other alternatives, but none as comforting as investing with a fund manager who has successfully managed a product in both good and bad times.
Conclusion
A mutual fund brings together a group of people and invests their money in stocks, bonds, and other securities.
The advantages of mutuals are professional management, diversification, economies of scale, simplicity and liquidity.
The disadvantages of mutuals are high costs, over-diversification, possible tax consequences, and the inability of management to guarantee a superior return.
There are many, many types of mutual funds. You can classify funds based on asset class, investing strategy, region, etc.
Mutual funds have lots of costs.
Costs can be broken down into ongoing fees (represented by the expense ratio) and transaction fees (loads).
The biggest problems with mutual funds are their costs and fees.
Mutual funds are easy to buy and sell. You can either buy them directly from the fund company or through a third party.
Mutual fund ads can be very deceiving.
The advantages of mutuals are professional management, diversification, economies of scale, simplicity and liquidity.
The disadvantages of mutuals are high costs, over-diversification, possible tax consequences, and the inability of management to guarantee a superior return.
There are many, many types of mutual funds. You can classify funds based on asset class, investing strategy, region, etc.
Mutual funds have lots of costs.
Costs can be broken down into ongoing fees (represented by the expense ratio) and transaction fees (loads).
The biggest problems with mutual funds are their costs and fees.
Mutual funds are easy to buy and sell. You can either buy them directly from the fund company or through a third party.
Mutual fund ads can be very deceiving.
Buying and Selling
You can buy some mutual funds (no-load) by contacting the fund companies directly. Other funds are sold through brokers, banks, financial planners, or insurance agents. If you buy through a third party there is a good chance they'll hit you with a sales charge (load).
That being said, more and more funds can be purchased through no-transaction fee programs that offer funds of many companies. Sometimes referred to as a "fund supermarket," this service lets you consolidate your holdings and record keeping, and it still allows you to buy funds without sales charges from many different companies. Popular examples are Schwab's OneSource, Vanguard's FundAccess, and Fidelity's FundsNetwork. Many large brokerages have similar offerings.
Selling a fund is as easy as purchasing one. All mutual funds will redeem (buy back) your shares on any business day. In the United States, companies must send you the payment within seven days.
The Value of Your Fund
Net asset value (NAV), which is a fund's assets minus liabilities, is the value of a mutual fund. NAV per share is the value of one share in the mutual fund, and it is the number that is quoted in newspapers. You can basically just think of NAV per share as the price of a mutual fund. It fluctuates everyday as fund holdings and shares outstanding change. When you buy shares, you pay the current NAV per share plus any sales front-end load. When you sell your shares, the fund will pay you NAV less any back-end load.
That being said, more and more funds can be purchased through no-transaction fee programs that offer funds of many companies. Sometimes referred to as a "fund supermarket," this service lets you consolidate your holdings and record keeping, and it still allows you to buy funds without sales charges from many different companies. Popular examples are Schwab's OneSource, Vanguard's FundAccess, and Fidelity's FundsNetwork. Many large brokerages have similar offerings.
Selling a fund is as easy as purchasing one. All mutual funds will redeem (buy back) your shares on any business day. In the United States, companies must send you the payment within seven days.
The Value of Your Fund
Net asset value (NAV), which is a fund's assets minus liabilities, is the value of a mutual fund. NAV per share is the value of one share in the mutual fund, and it is the number that is quoted in newspapers. You can basically just think of NAV per share as the price of a mutual fund. It fluctuates everyday as fund holdings and shares outstanding change. When you buy shares, you pay the current NAV per share plus any sales front-end load. When you sell your shares, the fund will pay you NAV less any back-end load.
The Costs
Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance.
What's even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for.
Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (loads).
The Expense Ratio
The ongoing expenses of a mutual fund is represented by the expense ratio. This is sometimes also referred to as the management expense ratio (MER). The expense ratio is composed of the following:
• The cost of hiring the fund manager(s) - Also known as the management fee, this cost is between 0.5% and 1% of assets on average. While it sounds small, this fee ensures that mutual fund managers remain in the country's top echelon of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is $2.5 million - fund managers are definitely not going hungry! It's true that paying managers is a necessary fee, but don't think that a high fee assures superior performance.
• Administrative costs - These include necessities such as postage, record keeping, customer service, cappuccino machines, etc. Some funds are excellent at minimizing these costs while others (the ones with the cappuccino machines in the office) are not.
• The last part of the ongoing fee (in the United States anyway) is known as the 12B-1 fee. This expense goes toward paying brokerage commissions and toward advertising and promoting the fund. That's right, if you invest in a fund with a 12B-1 fee, you are paying for the fund to run commercials and sell itself!
On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers.
Are high fees worth it? You get what you pay for, right?
Wrong.
Just about every study ever done has shown no correlation between high expense ratios and high returns. This is a fact. If you want more evidence, consider this quote from the Securities and Exchange Commission's website:
"Higher expense funds do not, on average, perform better than lower expense funds."
Loads, A.K.A. "Fee for Salesperson"
Loads are just fees that a fund uses to compensate brokers or other salespeople for selling you the mutual fund. All you really need to know about loads is this: don't buy funds with loads.
In case you are still curious, here is how certain loads work:
• Front-end loads - These are the most simple type of load: you pay the fee when you purchase the fund. If you invest $1,000 in a mutual fund with a 5% front-end load, $50 will pay for the sales charge, and $950 will be invested in the fund.
• Back-end loads (also known as deferred sales charges) - These are a bit more complicated. In such a fund you pay the a back-end load if you sell a fund within a certain time frame. A typical example is a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if you sell in the first year, 5% in the second year, etc. If you don't sell the mutual fund until the seventh year, you don't have to pay the back-end load at all.
A no-load fund sells its shares without a commission or sales charge. Some in the mutual fund industry will tell you that the load is the fee that pays for the service of a broker choosing the correct fund for you. According to this argument, your returns will be higher because the professional advice put you into a better fund. There is little to no evidence that shows a correlation between load funds and superior performance. In fact, when you take the fees into account, the average load fund performs worse than a no-load fund.
What's even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for.
Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (loads).
The Expense Ratio
The ongoing expenses of a mutual fund is represented by the expense ratio. This is sometimes also referred to as the management expense ratio (MER). The expense ratio is composed of the following:
• The cost of hiring the fund manager(s) - Also known as the management fee, this cost is between 0.5% and 1% of assets on average. While it sounds small, this fee ensures that mutual fund managers remain in the country's top echelon of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is $2.5 million - fund managers are definitely not going hungry! It's true that paying managers is a necessary fee, but don't think that a high fee assures superior performance.
• Administrative costs - These include necessities such as postage, record keeping, customer service, cappuccino machines, etc. Some funds are excellent at minimizing these costs while others (the ones with the cappuccino machines in the office) are not.
• The last part of the ongoing fee (in the United States anyway) is known as the 12B-1 fee. This expense goes toward paying brokerage commissions and toward advertising and promoting the fund. That's right, if you invest in a fund with a 12B-1 fee, you are paying for the fund to run commercials and sell itself!
On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers.
Are high fees worth it? You get what you pay for, right?
Wrong.
Just about every study ever done has shown no correlation between high expense ratios and high returns. This is a fact. If you want more evidence, consider this quote from the Securities and Exchange Commission's website:
"Higher expense funds do not, on average, perform better than lower expense funds."
Loads, A.K.A. "Fee for Salesperson"
Loads are just fees that a fund uses to compensate brokers or other salespeople for selling you the mutual fund. All you really need to know about loads is this: don't buy funds with loads.
In case you are still curious, here is how certain loads work:
• Front-end loads - These are the most simple type of load: you pay the fee when you purchase the fund. If you invest $1,000 in a mutual fund with a 5% front-end load, $50 will pay for the sales charge, and $950 will be invested in the fund.
• Back-end loads (also known as deferred sales charges) - These are a bit more complicated. In such a fund you pay the a back-end load if you sell a fund within a certain time frame. A typical example is a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if you sell in the first year, 5% in the second year, etc. If you don't sell the mutual fund until the seventh year, you don't have to pay the back-end load at all.
A no-load fund sells its shares without a commission or sales charge. Some in the mutual fund industry will tell you that the load is the fee that pays for the service of a broker choosing the correct fund for you. According to this argument, your returns will be higher because the professional advice put you into a better fund. There is little to no evidence that shows a correlation between load funds and superior performance. In fact, when you take the fees into account, the average load fund performs worse than a no-load fund.
Different Types Of Funds
No matter what type of investor you are, there is bound to be a mutual fund that fits your style. According to the last count there are more than 10,000 mutual funds in North America! That means there are more mutual funds than stocks.
It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk - it's never possible to diversify away all risk. This is a fact for all investments.
Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds.
Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky.
The money market
consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD).
Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cashflow to investors. As such, the audience for these funds consists of conservative investors and retirees.
Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.
Balanced Funds
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.
Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities.
For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).
Global/International Funds
An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country.
It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification. Although the world's economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of your home country.
It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk - it's never possible to diversify away all risk. This is a fact for all investments.
Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds.
Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky.
The money market
consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD).
Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cashflow to investors. As such, the audience for these funds consists of conservative investors and retirees.
Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.
Balanced Funds
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.
Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities.
For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).
Global/International Funds
An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country.
It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification. Although the world's economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of your home country.
Disadvantages of Mutual Funds
• Professional Management - Did you notice how we qualified the advantage of professional management with the word "theoretically"? Many investors debate whether or not the so-called professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still takes his/her cut. We'll talk about this in detail in a later section.
• Costs - Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that we have devoted an entire section to the subject.
• Dilution - It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.
• Taxes - When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.
• Costs - Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that we have devoted an entire section to the subject.
• Dilution - It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.
• Taxes - When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.
Advantages of Mutual Funds
• Professional Management - The primary advantage of funds (at least theoretically) is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money.
• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions.
• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis.
• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money.
• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions.
• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis.
Mutual Funds:What are they?
The Definition
A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit.
Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.
A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit.
Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.
Introduction to mutual funds
As you probably know, mutual funds have become extremely popular over the last 20 years. What was once just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or one half of the households in America, invest in mutual funds. That means that, in the United States alone, trillions of dollars are invested in mutual funds.
In fact, to many people, investing means buying mutual funds. After all, it's common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of funds ends. It doesn't help that mutual fund salespeople speak a strange language that is interspersed with jargon that many investors don't understand.
Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutuals isn't as easy as throwing your money at the first salesperson who solicits your business.
In fact, to many people, investing means buying mutual funds. After all, it's common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of funds ends. It doesn't help that mutual fund salespeople speak a strange language that is interspersed with jargon that many investors don't understand.
Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutuals isn't as easy as throwing your money at the first salesperson who solicits your business.
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